Xi’s re­form gam­bit

When Deng Xiaop­ing ini­ti­ated China’s mar­ket-ori­ented re­forms 35 years ago, he – and the Chi­nese Com­mu­nist Party – was tak­ing the big­gest po­lit­i­cal risk since the found­ing of the Peo­ple’s Repub­lic in 1949. When Pres­i­dent Xi Jin­ping un­veiled his own re­form agenda at last year’s Third Plenum of the 18th CCP Congress, he was tak­ing an equally large risk. Will his strat­egy pay off?

In 1979, Deng was in a dif­fi­cult sit­u­a­tion. He knew that the shift from cen­trally planned egal­i­tar­ian so­cial­ism to­ward mar­ket-ori­ented cap­i­tal­ism could desta­bilise the CCP’s rule, and the un­equal ac­cu­mu­la­tion of wealth in the short term could cause sig­nif­i­cant so­cial and po­lit­i­cal di­vi­sion. But, with China on the verge of eco­nomic and so­cial col­lapse, fol­low­ing the decade-long chaos of the Cul­tural Revo­lu­tion, he had to take ac­tion – and there were few, if any, al­ter­na­tives avail­able.

The re­forms turned out to be ex­tremely re­ward­ing: more than three decades of dou­ble-digit eco­nomic growth fol­lowed their im­ple­men­ta­tion. More­over, they al­lowed the CCP to re­tain its hold on power. But they ben­e­fited some peo­ple and re­gions much more quickly than oth­ers – a prob­lem that was tougher to ad­dress than Deng had an­tic­i­pated.

Xi’s re­forms, like Deng’s, re­flect the ab­sence of al­ter­na­tives. Not only has China’s labour-in­ten­sive, in­vest­ment-led growth model run out of steam; bu­reau­cratic in­ef­fi­cien­cies and per­va­sive cor­rup­tion – not to men­tion se­vere and wors­en­ing pol­lu­tion – are also dam­ag­ing China’s long-term prospects. Only by ad­dress­ing th­ese weak­nesses and shift­ing to an in­no­va­tion-based, en­vi­ron­men­tally sus­tain­able growth model can the coun­try con­tinue to pros­per – and ul­ti­mately achieve high-in­come sta­tus.

The dif­fer­ence be­tween the two re­form ef­forts is that Xi must also ad­dress the short­com­ings of Deng’s work. Deng mis­tak­enly be­lieved that the state, which re­tained its cen­tral role in the econ­omy, would be able to use new mar­ket­gen­er­ated re­sources to cor­rect the short-run in­equal­i­ties cre­ated by his re­forms. But the bu­reau­cracy and its priv­i­leged net­works ben­e­fited most, and a sec­ond, non­mar­ket source of in­equal­ity – en­demic of­fi­cial cor­rup­tion – be­came en­trenched. That is why Xi’s anti-cor­rup­tion cam­paign was a crit­i­cal pre­cur­sor to re­form.

In other words, beyond com­plet­ing China’s trans­for­ma­tion into an open, mar­ket-based econ­omy, Xi must es­tab­lish a strong rule of law that ap­plies to all, while ad­dress­ing acute in­equal­ity of in­come, op­por­tu­nity, wealth, and well­be­ing. For this rea­son, Xi must pur­sue re­forms that al­low peo­ple, money, re­sources, in­for­ma­tion, and com­pa­nies to move more freely across sec­tors, re­gions, and na­tional bor­ders.

The re­sult­ing con­ver­gence of wealth and op­por­tu­ni­ties would gen­er­ate mas­sive eco­nomic and so­cial gains. But, by ef­fec­tively trans­form­ing the eco­nomic ge­og­ra­phy of China, Asia, and the world, lib­er­al­i­sa­tion would also lead to sig­nif­i­cant cre­ative de­struc­tion. Fur­ther­more, mar­ket forces could re­duce in­equal­ity in the longer term only if China’s au­thor­i­ties tol­er­ated the short-term in­equal­i­ties cre­ated by fluc­tu­a­tions in prices for hous­ing, stocks, la­bor, nat­u­ral re­sources, and cur­rency.

The prob­lem is that the Chi­nese bu­reau­cracy prefers sta­bil­ity, and it has strong in­cen­tives to strengthen its own po­si­tion rel­a­tive to the mar­ket, thereby ex­ac­er­bat­ing power in­equal­i­ties and damp­en­ing in­no­va­tion and growth. Yet the bu­reau­cracy re­mains in­te­gral to the im­ple­men­ta­tion of any pol­icy that pro­motes so­cial co­he­sion.

To mit­i­gate the se­ri­ous sys­temic risks stem­ming from the power of China’s over­ween­ing, cor­rupt man­darins, Xi must re­bal­ance their in­cen­tives. He is al­ready work­ing to elim­i­nate graft, re­strict the scope of ad­min­is­tra­tive ap­provals, re­duce the state-owned sec­tor’s ad­van­tages, clar­ify prop­erty rights in land, and sim­plify wel­fare, tax, and fi­nan­cial reg­u­la­tions. Beyond re­duc­ing sys­temic risks, th­ese ef­forts – if they are sus­tained – could gen­er­ate “re­form div­i­dends” over time.

But the in­cen­tive prob­lem is not con­fined to the bu­reau­cracy. Sys­temic re­form re­quires recog­nis­ing and aton­ing for two orig­i­nal sins: not only that of bu­reau­crats who made money by abus­ing their power, but also that of cap­i­tal­ists who made money by break­ing the rules.

This chal­lenge is best il­lus­trated in the com­pe­ti­tion be­tween state-owned en­ter­prises and pri­vate firms. The fail­ure of pri­vate firms that lack ac­cess to sub­si­dies or af­ford­able fi­nanc­ing de­ters oth­ers from in­no­vat­ing and chal­leng­ing the sta­tus quo. Mean­while, SOEs – which can invest in ex­cess ca­pac­ity, record net losses (of­ten through cor­rup­tion and in­com­pe­tence), and count on gov­ern­ment sub­si­dies – never face a reck­on­ing.

The im­pli­ca­tion is that macroe­co­nomic poli­cies like low in­ter­est rates and easy ac­cess to credit should be used to en­sure equal ac­cess to credit for all qual­i­fied com­pa­nies, based on their com­pet­i­tive­ness, not their own­er­ship. Un­for­tu­nately, im­ple­ment­ing such mea­sures would en­tail mi­cro-level bu­reau­cratic in­ter­ven­tion, lead­ing to fur­ther ex­pan­sion of state pow­ers. That is why the bu­reau­cracy must be given in­cen­tives – higher salaries, clear per­for­mance in­di­ca­tors, and aware­ness that abuses of power will not be tol­er­ated – to aban­don the mi­cro-man­age­ment of mar­ket ac­tiv­i­ties.

China’s re­cent re­lax­ation of macroe­co­nomic pol­icy, de­spite on­go­ing mar­ket vo­latil­ity, is an im­por­tant step to­ward break­ing un­nec­es­sary bar­ri­ers to im­ple­ment­ing the re­forms needed to mit­i­gate sys­temic risks. Now that Xi’s an­ticor­rup­tion cam­paign has taken down some of the CCP’s big­gest “tigers,” it is time to fo­cus on struc­tural re­form.

With the right ap­proach and sus­tained po­lit­i­cal will, Xi’s risk-tak­ing can bring China the kind of re­turns that Deng’s did – and more.